Is China a Complete Joke?

It's not unreasonable to think that way.

It was almost five years ago now that our Motley Fool Global Gains research team started visiting China, regularly searching for overlooked investment opportunities in the country. We were attracted to the market for the same reasons every business and investor is attracted to China -- it's the world's fastest-growing economy and will someday be the largest as well. Furthermore, because of infrastructure development, rising consumer purchasing power, increasing demand for food and energy, and a growing need for higher quality health care, there's not an industry in the world that can look at China and not see the potential for a growth bonanza.

Investors bewareYet there are realities about China that make doing business and investing there very difficult -- particularly for foreigners. While we knew it was a relatively dicey business culture, aware of stories of companies keeping two or three sets of books, breaking contracts, bribing officials, and so on, our perspective was that the relative opportunity made it worth the real risks -- and that we could solve for the risk by doubling down on our assessments of management, demand massive margins of safety on any purchase, keeping our exposure to any individual Chinese company small, and getting some of our exposure to China through well-known multinationals.

More importantly, we believed that time was on our side. Our expectation was that business practices in China would get better over time. It turns out that may have been naive.

A tough week for ChinaWhile accusations of fraud against small Chinese reverse mergers have been ongoing, two more recent events illustrate just how dicey China really is and how it may not be improving. The first is the incredible story of Longtop Financial(NYSE: LFT), a Chinese financial software company that was at one time capitalized at more than $2 billion and counted some very savvy investors among its shareholder ranks. Following accusations of financial shenanigans, the company's auditor, Deloitte Touche, resigned. There's nothing very remarkable about that, but what is remarkable is the story Deloitte told in its letter of resignation.

Although Deloitte had already received confirmation letters from Longtop's banks concerning the balances in Longtop's accounts, Deloitte felt it necessary to go the extra mile and actually visit the banks. When they did so they discovered that Longtop's stated balances and the relevant confirmation letters did not match what they found at the bank when they accessed the accounts via tellers. In other words, some relatively senior person at Longtop's Chinese bank, which is undoubtedly state-owned, was complicit in helping Longtop deceive Deloitte and its investors. Unfortunately, Deloitte's letter does not name which Chinese bank or banks were involved, but my guess given Longtop's ostensible size is that it was a high-profile one. That means fraudulent practices may be systemic in China's financial system -- undermining any confidence foreign investors like us might have had.

Of course, many never considered Chinese banks to be upstanding corporate citizens. The fact that they were Longtop's principal customers was one reason we were never interested in the stock -- or that of peers such as Yucheng Technologies(Nasdaq: YTEC). It's also why we've never thought the way to invest in China was through the China 25 Index(NYSE: FXI), a popular Chinese investment that has better than 50% exposure to financials. Because Chinese banks are run by the government, they're known for having lax lending standards, loaning to pet projects, and propping up other state-owned enterprises in order for the Chinese government to preserve jobs. These banks are being run for somebody, but it's not shareholders.

Who else is complicit?The other shot fired across China's bow came from Microsoft(Nasdaq: MSFT) CEO Steve Ballmer, who noted in a speech in Beijing that the company only generates 5% of its sales in China despite the fact that there are almost as many computers sold in China as in the U.S., which accounts for 58% of the company's $62 billion of sales. The reason? Piracy. The Chinese government simply does not choose to protect trademarks and intellectual property, and particularly foreign trademarks and intellectual property. After all, piracy creates jobs in China and makes things like software more affordable for Chinese citizens -- both realities that help keep the population in check.

This, however, is starting to change, which helps explain why Ballmer was in Beijing in the first place opening a new $400 million research and development facility. The reason, though, is not that the Chinese government is suddenly respectful of foreign intellectual property, but rather because Chinese companies such as Qihoo 360 Technology(NYSE: QIHU), Li Ning, BYD, and others are starting to develop valuable intellectual property of their own. But the country still has a long way to go.

Are we crazy?Given this context, why are we going back to China again this year in search of investment ideas? First, we still believe in China's long-term economic opportunity. There will be significant growth in the country over the next few decades even if investors need to work hard to figure out how to benefit from that growth.

Second, China does not want to be considered a corrupt laughingstock by the world forever. Although recent events have been difficult for investors, their coming into the spotlight will force the central government to act. The first evidence that this is happening was the rumor last week that China will finally let the Public Company Accounting Oversight Board auditors in the country. It will also be interesting to see whether any Chinese bank officials are detained in conjunction with the Longtop fraud.

Put those facts together and while China has not come as far in five years as we would have liked, we continue to believe the country is making progress that will ultimately benefit patient, long-term investors. We also think that by getting on the ground in the country, we can identify management teams that are ahead of the curve, helping China and its capital markets get to where they need to be. If we can align ourselves with those types of executives, investors like us can still make good money in China.

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